Summary ins economics

7/28/2019 Summary ins economics

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Summary of Institutional Economicsan introduction

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Institutional Economics Summary

Chapter 1

Transactions can sometimes be problematic, and thats when institutions are needed.

Institutions are about facilitating transactions ofproducts between actors.Actor: any decision-maker in an economic activity

Product: catch-all term for any entity that can be transacted

Three types of transaction

- Market transaction (Bargaining transaction): Between individual buyers and sellers

- Managerial transaction: Between a legal superior and a legal inferior

- Political transaction: Agreed on by decision-makers who have legal authority to

determine how wealth should be distributed

By use of transactions people want to maximize their utility: optimizing behavior (rational).Sometimes transactions can also benefit a third party, this is called the invisible hand. When

people strive to maximize their utility they sometimes do so at the cost of someone else. It is

called opportunistic behavior: trying to achieve ones goals through lying and cheating.

Perfect competition is characterized by its efficient outcome. Economic welfare in that case

is maximized for society at large.

Static efficiency: Productive and allocative efficiency

Dynamic efficiency: When innovation improves production or distribution techniques

Five market imperfections (leading to efficiency losses)

- Imperfect information

Unequal distribution of information. One actor having more knowledge than the

other: asymmetric information. Also possible that all actors have imperfect

information, e.g. with online auctions (winners curse)

- Market power

The ability of a single seller or a group of sellers to set the price above the level of the

marginal costs. Monopoly, oligopoly, monopolistic competition.

Also on the demand side, one single buyer. Monopsony.

- Pure public goods

Products from which people cannot be excluded. People can use the product without

paying for it once it is in use:free riding. No one in the market will want to produce

this public goods.

- Externalities and (de)merit goods

An economic side effect not addressed by the market, and consequently not

reflected in the prices. Can be positive (benefits) or negative (costs).

Merit goods: products that are good for the consumers themselves and have a

positive external effect.

Demerit goods: products that are bad for the direct users and in addition have

negative external effects.

- Natural monopolies

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Production technology leads to continuously decreasing average costs. The market

does not allow for two or more firms in the market. A natural monopoly can than set

the price above marginal costs to maximize profits.

Institutional Economics is interested in minimizing transaction costs. Before transacting the

actors have to incur costs to find out how and where transaction opportunities occur and

about the possible risks and uncertainties. These costs consist of:- Search and information costs (before)

- Costs to draft, to negotiate and to conclude the contract(before)

- Monitoring costs and enforcement costs (after): make sure the other party commits

to the agreement, and when not so the enforcement of the other party

Institutions are systems of hierarchical man-made rules that structure behavior and social

interaction.

Formal institutions (public): rules of behavior that are designed by a public authority with

legislative, executive and judiciary power. E.g. laws and governmental regulations.

Informal institutions (private): rules of behavior that have been developed gradually andspontaneously and do not need any legal enforcement because the rules are sanctioned by

the private parties themselves (self-regulating) or because of self-interest to follow the rules

(self-enforcing). E.g. WTO or boycotting.

Business is done in institutional environments. Each environment has its own hierarchy of

institutions: values, norms, conventions, laws and specific rules.

- Values: generally-held preferences about pursuable goals (what people consider to

be good)

- Norms: generally-held opinions about how to achieve these values (how people

should behave to live op to these goods)- Conventions: practical rules that structure behavior in complex situations (to help

structure people to behave according to their norms)

- Laws: formalized rules enacted by the government, in the shape of codified norms

and conventions (sanctions through legal enforcement for situations when people

break existing rules)

Institutional environment is not static but subject to ongoing changes. An institution that has

been successful for years may suddenly not be effective enough and may have to change

due to developments in society.

But when are institutions effective? Two conditions must hold:- A sufficient percentage share of individuals must subscribe to the institution

- There must be credible sanctions to prevent the rest from acting against the norm

For rules to be accepted, they need three requirements: be general, certain and open.

This means they must be nondiscriminatory (apply to all people), they must be transparent

and reliable (all know what the rules imply) and they should be flexible (permit actors to

proceed in response to new circumstances).

Enforceable sanctions can be negative or positive. Negative sanctions deal with norm-

violating behavior,positive sanctions are rewards or encouragements to behave according to

the rules (e.g. performance based pay).



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Institutions both enable and constrain human behavior.

Enabling institutions like language and money help international trade.

Constraints like limitations and bans prevent actors from possible harming of others.

Institutional environments are closely linked to economic systems: framework of interrelated

institutions that influence the ways in which people organize production, consumption and

distribution of goods and service in a particular society.Macro perspective, two extreme forms (ideal types):

- Pure market economy

- Centrally planned economy

Do not exist in real life, every system is a mixed form of the two, with one country more

centrally planned than the other.

Micro perspective: point of view of market

In this context governance structures are defined as institutional frameworks (market

contracts, private firms, regulatory public agencies)

It describes who owns what, who is allowed to make decisions etc.

Institutional Economics deals with the subject matter in two different ways:

- Comparative static

- Dynamic

Static efficiency approach: focus on optimizing under given constraints.

Given the institutional environment and the characteristics of actors, which governance

structure minimizes transaction costs?

Static vested interest approach: interest groups protect their own interests.

Given the institutional environment and the characteristics of actors, which governance

structure is chosen when powerful interest groups protect their vested interests?

Dynamic efficiency approach: process of how institutional change develops over time.

How do institutional changes come about when actors operate out of an efficiency

perspective?

Dynamic vested interest approach: change of institutions because of powerful interest

groups protecting their interests.

How do institutional changes come about when actors operate out of a vested interest

perspective?

Institutionalists investigate both the reasons for efficiency and reasons for vested interest inexplaining the existence of institutions and their changes.

Institutions are one of the main reasons there are such big disparities between developed

and developing countries. With poor institutions, there are fewer transactions and this

means lower growth.

Also specialization can only work properly with a well working institutional framework, as

people need to feel secure of property rights in order for an economy to flourish.



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Chapter 2 pg. 55 57 & 60 78

All disciplines make abstractions about reality with purpose of understanding basic causal

mechanisms of a phenomenon. This is important as it can lead to predictions of changes.

For the purpose of clarity, scientists produce models, which represent a phenomenon.

Theories are then formed to explain a phenomenon.

Falsification = no theory is ever proven to be right, its only not yet falsified

Objective = theoretical or societal relevance of a research project

Anchoring = embedding the research project in prior work in your field

Theories consist of two types of variables

- Endogenous variables (dependent): variable to be explained by the model

- Exogenous variables (independent): variable not explained by the model

Theory should be as simple as possible; exogenous variables kept to a minimum.

Extraneous variable might also influences endogenous but not incorporated in model

Mediator = intervening variable in a theory. X through Y -> Z

Moderator = variable that affects the relationship between two other variables (e.g. regulations)

Characteristics of the NCE (Neoclassical Economics) model

- Precise distinctions between endogenous and exogenous variables

- Precise descriptions of the actors (characteristics and rules of behavior)

- Clear description of the environment in which they operate (market structures)

- Precisely formulated relationship between the environment and the actors

NCE models operate in an institutional vacuum, they are not exogenous variables but they are just

absent or assumed to function perfectly. In IE they do not operate in an institutional vacuum, but

they matter as exogenous variables.

In explaining differences between countries in their levels of investments, types of innovations,

distribution of power and level of economic growth, institutions are a key exogenous variable, as

they reduce uncertainties and facilitate efficient decision-making, thus improving economic growth.

Two schools in Institutional Economics: NIEand OIE

New Institutional Economics

The theory aims at explaining why different governance structures (endogenous variable) exist.

Values, norms, conventions, laws and regulations taken as given (exogenous). (


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another. Actors make use ofprocedural rationality: the actor relies on what she learned in the past

and what has proved to work in the community to which she belongs. No maximizing behavior but

satisficing behaviorinstead, in which the goal is to reach aspiration levels, with which the actor is

satisfied. Instead of just opportunistic behavior there is also trust, entailing low transaction costs.

Also not always rational behavior but sometimes based on habits, doing without thinking.

In OIE, creativity and learning are central characteristics. Actors are rooted in an environment ofvalues and norms that structure their mental maps, a model against which they perceive the world

around them, shared with the community.

Also much attention to power of individuals and vested interest groups. Understanding behavior of

economic actors thus demands an analysis of their power base.

Comparing NIE and OIE

Main difference: OIE always puts the emphasis on dynamics and change from a broad description

perspective, whereas NIE puts the emphasis on an efficient analysis of the origins and working in

institutions as well an efficiency analysis of changes in institutions. See Table 2.1 for overview.

Chapter 3

Static approach of Institutional Economics studies the ways in which a given institutional

environment has an impact on economic decision-making.

NIE dominant school of thought. Key concept is efficiency. Three theories closely connected to NIE

will be introduced that shed light on how people perform transactions.

Property rights theory

Private property leads to guardianship and motivates the owner to maximize the utility of the good.

This applies when a person has the exclusive right to:

- make use of the good

- earn income from it

- manage the good and to transfer control of it to another party (right of disposal)This is called a bundle of property rights.

Holder of all three of them is called the owner of the good.

Property right brings rights and obligations.

Two types of problems involving property rights

- The designing and assigning of property rights (what property rights system?)

- The exercising (enforcing) of property rights (can be unclear who is the holder of the right)

Systems of property rights are assigned to prevent conflicts about ownership, as these are usually

unproductive or disruptive.

Two extreme systems:

- Privately owned goods accompanied by full excludability- Shared (common) and public property, exploitation not restricted to a single party.

Goods can be characterized as being exclusive or nonexclusive (others can effectively be prevented

from using the good, or not) and as rivalor nonrival(consumption of the good reduces the amount of

the good available to others).

Exclusive

YES NO

Rival YES Private good Common property resource

NO Club good Pure public good

Division of goods according to their characteristics

Property rights can both be assigned to tangible (physical) and intangible (nonphysical) goods.



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Positive effect of property rights: resources used as efficiently as possible, stimulate overall economic

growth. This is only possible if people believe their property rights are ensured, they need not to

incur very high exclusion costs (expenses to prevent others from using the property).

Free goods are not at all scarce, supply exceeds demand at all price levels: price is zero. No need for

property rights, no one has to be excluded. E.g. the air.Most free goods have become shared (common) property, they are nonexclusive but they have

become rival because of increasing scarcity (clean water, fishing grounds). Continuous exploitation is

possible if managed carefully. Otherwise the stock is bound to be exhausted and may disappear,

known as the tragedy of the commons.

Pure public goods are always accompanied by positive externalities. People can enjoy the good

without paying for its use. But who will finance them? If too many people free ride, it may turn out to

be too expensive to produce this good. This is undesirable in many cases like dikes. They must be

there to protect the people, but no one is willing to pay for it. This way pure public goods are often

supplied by the government and financed by taxing.

Three welfare enhancing reasons why governments would want to control powerful organizations

are to prevent natural monopolies, to assure private citizens that they can expect fair treatment frominstitutions as the police and the military and thirdly to promote the consumption of merit goods or

to aid weaker members of society.

When enforcing public rights, informal institutions are less costly but in modern societies not enough

to make it function smoothly. Thats why the implementation of formal state-enacted rules are

needed. Also negative externalities form a problem in enforcing property rights.

Coase theorem shows that parties will be able to reach an optimal solution to such a problem

without state intervention if these three conditions hold:

- It must be clear who possesses the property rights

- Negotiations about solving the problem must be costless (no transaction costs)

- Wealth effects are not allowed to occur

When in the trading process all social costs inflicted on third parties are being taken into account

when determining the level of production, the negative externality has become completely

internalized.

In real life this is often not the case and not all three conditions apply.

Different property rights systems generate different kinds ofincentives.

Free riding can cause problems in common property systems, which generate social costs and

enforcement problems. Sometimes solutions lie in government taxation. But the drawback is that

nonusers then also have to pay.

Information goods (intangible, like a recipe or a song) characterize nonrivalness and nonexlusiveness,

but secrecy(informal) and copyrights/patent rights (formal) are there to protect the goods and

stimulate other to become innovative (knowing the law will protect their efforts from others).

Employment relationship:the employer has the incentive to maximize the firms profits, but the

employees do not have the incentive to work hard. Employer must incur additional costs to monitor

worker and to prompt them to apply greater effort.

Contract theories

A contractis an oral or written agreement between two parties who consent in advance to exchange

goods or services (property rights), whether or not in return for a certain payment.

Formal contracts are legally enforceable promises.

Informal, implicit contracts facilitate compliance with agreement (no need for enforcement).

In an ideal world where parties act fully rational and are fully informed, complete contracts can be

drawn up. In reality there is however incomplete information and bounded rationality which leads to

incomplete contracting.



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Difference between:

- Simultaneous contract (spot transaction), an immediate exchange of property rights so both

parties comply straight away and the contractual relationship ends immediately.

- Nonsimultaneous contract, the agreement will be fulfilled at a point in time in the future, this

increases the risks of noncompliance.

Agency theoryrefers to formal contracts that are legally enforceable agreements.

It deals with the question how to incorporate the right incentives into a contract to prevent

opportunistic behavior and reach an efficient outcome.

Agency theory distinguishes between theprincipal(the party that commissions the task) and the

agent(the party that receives the task).

This principal-agent relationship can become a principal-agentproblem when the following holds:

- The principal and the agent have conflicting interest

- There is asymmetric information

When these two conditions hold, ex-ante (before the contract) or ex-post (after the contract)

opportunism will occur.

Adverse selection can happen when there is shortage of information before (ex-ante) the contracthas been signed.

Moral hazardbehavior refers to the situation when one of the parties doesnt do what is expected of

him after (ex-post) the contract has been signed, without the other side finding out.

The efficiency losses resulting from moral hazard behavior are also called agency costs, of which are

three categories:

- Monitoring expenditures, steering the agent in the desired direction by establishing

appropriate incentives for the agent. Negative incentives are strict supervision and

punishment,positive incentives are compliments or merit pay.

- Bonding expenditures, spending resources aimed at signaling to the principle that he does

serve the interests of the principle. So a rise in bonding costs will lower the need for

monitoring and thus decrease monitoring costs.

- Residual loss,the principles welfare loss that still remains even at optimal levels for

monitoring and bonding.

Implicit contract theoryrefers to informal contracts with which agent comply because it is in their

best interest to do so. Also called self-enforcing agreement.

Several self-enforcing and self-regulating mechanisms are distinguished:

- The threat of losing ones reputation.

- Tit for tat, deceiving your business partner may cause him to do the same to you.

- Installing third parties to resolve problems and to evaluate performance.

- Mutual commitments, when contracting partners have invested in each other, this leads to

bonding effects. Strong form of bonding is the use ofhostages (demanding extra security

when transacting a high value product, like a down-payment).

- Unification of parties, when parties decide to merge.

An example of a contract that contains several implicit mutual understandings and self-enforcing

mechanisms is the open-endedor relationalcontract. It refers to an agreement over an

indeterminate period.

Transaction cost economics (TCE) stress the ex-post costs that result from the contracting and

searches for the most efficient governance structure.

When a products features are well known or can easily be observed before the purchase the good is

a search good. Products for which quality characteristics are difficult to observe in advance are called

experience goods.



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Three main dimensions in which transactions differ:

- Asset specificity, if one of the contracting parties has made transaction specific investments,

this results in high dependence, which may be abused by other parties. This is known as the

hold-up problem: because the holder of the transaction-specific property right has no

substitution possibilities and is thus highly dependent, his contracting partner may actopportunistically and exploit this situation.

There are 5 different types of asset specificity to be distinguished:

- Site specificity, the resources in which is invested are highly immobile

- Physical asset specificity, investment in equipment that is designed for a very specific

purpose

- Human asset specificity, firm-specific knowledge (human capital), not to use in

different firms

- Dedicated assetspecificity, a general investment made specifically with the objective

of selling a large amount of product to one particular costumer

- Intangible asset specificity, immaterial valuables such as brand name capital

- Uncertainty, transactions can differ in uncertainties both with respect to behavior of thecontracting parties and with respect to market developments.

- Frequency, if parties have regular dealings this implies that they will develop certain routines

and implicit mutual understanding, and this will reduce the need for formal enforcement

mechanisms and thus lower transaction costs.

A governance structure deals with all the necessary steps to coordinate the transaction.

The marketas a governance structure lets the actors be autonomous, as compared to the firm, which

is a hierarchy in which the actors are no longer autonomous.

The government also plays a role, and sometimes even a dominating one. In that case,private

ordering is replaced bypublic ordering (needed in sectors where competition needs regulation to

prevent firms from abusing a dominant position).

Moving left to right on the contracting scheme (p. 124):

- In an ideal marketthere is no asset specificity and there is no need for safeguards as perfect

competition rules out opportunistic behavior.

- In market hazardthere is some asset specificity but the parties to the market contract have

not incorporated any safeguards to protect themselves against possible hazard.

- Institutionalized markethas increasing asset specificity and we see that safeguards are being

built in.

- When asset specificity increases further, actors in the market could opt for some form of

cooperation with others , thereby relinquishing their autonomy, this is called a hybrid.

- A very high degree of asset specificity may incite actor to organize transactions within afirm,

then safeguards take the form of administrative safeguards.

- When private ordering is replaced by public ordering, we subsequently encounter

government regulation of private actors.

- State-owned enterprise

Vested interest approach

Property rights often not used in an efficient way but allocated in the advantage of the ones with

power, certain groups may receive preferential treatment when it comes to paying taxes, and

receiving subsidies and special political favors.

Rival theory of the agency theory is the managerial power theory, which state that powerful

executive officers are in a position to use their discretion and alone determine the level and type of

their salary.



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Governance structures often arise out of power motives, or are sustained for that reason. So instead

of operating for the purpose of increasing public welfare, they rather operate for the welfare of the

ruler and his supporting factions in society.

Chapter 5 pg. 167 185

The market is preceded by institutions. Exchanges involve property rights and take place in a legal

framework. The market requires clearly defined property rights in order to perform its task of

allocating resources. Not only property rights are involved, but other institutions as well. The choice

of specific market institutions may be explained by the minimization of transaction costs. Reason to

choose different market institutions is that they reduce transaction costs.

Ideal perfectly competitive market is illustrated by spot markets: a market made up of buyers and

sellers whose relationship consists of a single exchange (homogeneous products, independence of all

parties and prices react immediately to changes in availability of the product).

Ideal market where theoretically no institutions are needed, but in practice institution are always

involved in real markets.

Contingent markets are an extension of spot markets. These markets not only limit commodities that

are characterized by physical properties and by place and time of availability, but also include a

differentiation of products with risks.

Contingent products are products that are not only defined by their physical properties, but also with

respect to time, place, environment and contingency. A contingent fee is a fee that has to be paid

only in the case of a favorable result (attorney).

Choice of governance structure is determined by the degree to which transaction-specific

investments are involved. But other conditions play a part as well.

Low asset specificity generates the lowest possible transaction costs when:

- Contracts are standard (classical contracts), this only applies to transactions that meet thefollowing criteria:

- Identity of the partners is irrelevant

- Nature of the transaction is defined precisely

- Formal (generally written) agreements are made

- Solutions to possible problems are organized in advance

- Contracts are restricted to the contracting parties

- Property rights are clear, without a well-designed system of private property rights, a market

would not be able to perform efficiently, if at all.

- Information about reputation is easily generated, as then the need to uphold ones

reputation is pressing in a competitive market environment where buyers can easily switch

to other sellers. This may help ensure that transactions can be enforced without third-partymonitoring.

- Risk is limited to contingencies, private actors in the market then adapt unilaterally to risks:

in order to enhance efficiency, people offer or seek safeguards (insurances) against risks.

Safeguards are designed to prevent from hazards. But there are no safeguards for all markets that do

not meet the ideal type. Fly-by-night transactions are market hazards for which no safeguards have

been designed. Happens when the costs of safeguarding are relatively high in comparison to the

price of the transaction.

When taking measures to safeguard transactions, benefits should always outweigh costs.

Free competitive markets have different forms of organization (auctions, supermarkets).Markets also differ based on the way that buyers are informed about the quality of the product.



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There is also no uniform way in which supply and demand meet each other, this can also differ

between different forms of markets.

Ex-ante opportunism, adverse selection, is characterized by hidden information.

Arises when there are no built-in safeguards to protect the trading partner who has the inferiorknowledge. In small communities, reputation mechanism could help. When trading in more

anonymous markets, a guarantee system backed up by a trustworthy umbrella organization

(Fairtrade Foundation, products labeled with the Fairtrade mark) can possible be the solution.

Ex-post opportunism, moral hazard, refers especially to hidden action.

An externality occurs when someones actions affect another party without compensation.

When negations are costless, a dispute regarding externalities will result in an efficient outcome.

When negations are not costless, we no longer get the most efficient outcome.

Efficiency may not be taken for granted, oligopolies and monopolies also operate in markets and may

exhibit their power in different forms. Market inefficiencies can then occur due to anti-competitivebehavior.

Market powercomes by degrees. Market power is defined as a situation with a price higher than

marginal costs.

Many producers, little heterogeneity: little market power.

Only two producers: lot of market power, however this is not always the case as the two may

compete so intensely that prices are driven down to marginal costs.

Monopoly power: highest degree of market power, however when it is very easy to enter the market

the potential competition could put very high pressure on the monopolist and force it to charge a

prices equal to marginal costs.

Therefore there is no direct relationship between the degree of market power and the number of

producers.

Administrated prices can be found in sectors planned by the state, they are set by administrators

whose main concern is different from profit maximization (maintain market share).

The phenomenon of manufactures setting prices to cover all costs and to provide a profit margin is

called mark-up pricing.

Oligopolies and monopolies have in addition to mark-up pricing the option of applyingprice

discrimination. This requires firms to be able to distinguish between buyers.

Creation of market power can be done through product differentiation, innovation and superior

products: competitive process. Can also be done through eliminating competition (hinder potential

entrants): anti-competitive process.

Another possibility ispredatory pricing, a short-term pricing policy that is loss-leading and therefore

unattractive to entrants that then will leave the market (investment in prolonging the monopoly).

Dominance can be created by anticompetitive means. There are three ways of eliminating

competition:

- Merging, two firms become one firm

- If each of the rivals knows that if they raise prices, the other will too (restricted to oligopoly)

- Explicit agreement to raise prices together

Chapter 6 pg. 201 - 211

In the neoclassical theory of firms, a firm is described as a product function that responds directly to

changes in costs and market demand. It focuses on the efficient allocation of resources. The

neoclassical firm is like a black box, of which only the input and output characteristics are known, but

not the internal functioning.



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Team production (within firms) generates a value that exceeds the value produced by the total

number of workers operating individually.

It requires an organizational structure that is different from the market as

- productivity in cooperating may be much higher

- some tasks may be performed that are impossible without cooperation- with team production some workers may try to shirk

Two conditions must be fulfilled before deciding to organize cooperation through a firm:

- generate a value that exceeds the value produced by workers operating individually

- must be possible at reasonable cost to estimate the individual contribution to total output

To reduce shirking one can check the behavior of team members himself. If it is more efficiently done

by someone else, a monitor can be hired.

All this is a rather limited approach, as there are many more stakeholders involved who must be

monitored. Stakeholders include banks, bondholders, shareholders, chief executive officers, other

executives, employees, customers, suppliers and creditors. All these have contracts with one

another. So a firm doesnt consist of one maximizing actor but rather of a whole range of them.This is called the nexus of contracts approach. Also the firm can enter into contracts as in corporate

law the firm is treated as legal entity.

Shareholders who have a residual claim have the best incentives to monitor the firm, as they receive

a variable amount of dividend depending on whether the firm is performing well.

A firm does not have duties that go beyond the obligation stipulate in the separate contract, so all

obligation of a firm should be interpreted in terms of separate contracts.

Firm is not a single system, but made up of subsystems (contracts between different stakeholders).

Transaction costs caused by using the price mechanism may be high when a whole series of contracts

is involved, for many repeated tasks it is much cheaper to offer one long-term contract. This is done

by embedding workers in a firm, and it is cheaper to allocate workers to tasks by command rather

than by price. This doesnt just save search and contracting costs but also wage costs, lower wage is

accepted in exchange for job security.

The higher the asset specificity of a product, the greater the chance the product will be made within

a firm rather than bought on the market, because this may require additional measures to secure

investment.

The level of asset specificity and the frequency of transactions are determinants of transaction costs.

Choice of governance structure is determined by the degree to which transaction-specific

investments are involved. But other conditions play a part as well.

The transaction costs in firms can be lower:

- because of the power of fiat, authority is given to top executives, internal conflicts can be

solved internally and thus save costs.

- if property rights are safeguarded more efficiently by administration controls instead of by

market transactions.

- as a result of the reputation of managers, the better the reputation, the less need for

detailed contracts and the lower the contract costs. Also a better reputation will give the

employer more motivated workers who can raise productivity. It also signals to shareholder

that the firm is a reliable investment and to customers that it sells high quality products.

- because a hierarchy is better equipped to deal with certain risks than the market, like risks of

fluctuations in demand, prices and supply. Firms adapt to risk by letting the management

decide about what is the best way to deal with the situation at hand (the power of fiat).

The separation of ownership and control might induce one of three possible outcomes:



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- Managers might become trustees who are scrupulously monitored on behalf of the passive

shareholders, this may have a negative effect on initiative.

- Managers might operate the company in their own interest.

- The modern corporation serves exclusively neither the sole interest of the passive owner, nor

the sole interest of the active managers in control.

In large companies where the owners have become shareholders at a distance, the owners have toensure that workers and managers act at the owners benefit. How can all different agents in the firm

be motivated not to abuse information asymmetries to their own advantage?

The owners can choose forpositive incentives (bonuses, promotion, recognition) or negative

incentives (demotion, dismissal). In general it is cheaper to give agents a positive incentive than to

monitor him.

The first category that can harm the value of the owners property rights are the managers. The

owners use several disciplinary mechanisms to control managers behavior. The three most common

are:

- Incentive pay, motivating managers by letting them share in the benefits.

- Monitoring devices, supervisory boards or obligatory reporting to shareholders.

- Outside pressures, reports on performance, bad results may lead to manager losing his job.The second category of agents that may have a negative effect on the value of the owners property

rights are all other employees in the firm. Employees may as an incentive receive a variable payment,

which encourages the worker to work harder because the salary depends on their own efforts.

A nonpecuniary incentive is to give personnel a say in company policies. This is called the granting of

participation or codetermination rights. The idea is that if employees are consulted on matters

concerning their working environment and if they are taken seriously, this will increase the

commitment and hence they will be more productive.

The set of institutions that are put in place to overcome agency costs that come from the separation

of ownership and control forms a system ofcorporate governance. This shows how a company is

managed, monitored, what its corporate principles and guidelines are and the supervision to which

the activities are subjected.

Two main types:

- The Anglo-Saxon model, the ideal type where the focus is on shareholder value. It not only

disciplines the managers but also guides shareholders in their decision to buy or sell shares of

the specific company. Here the influence of individual shareholders is small.

- The Continental European model, this system gives in comparison to the Anglo-Saxon model

more influence to stakeholders. The workers have a say in decision-making through work

councils and they are allowed to choose representatives on the supervisory board.

Mergers can be horizontal (between competitors), vertical (between supplier and costumer) or

diagonal (any other merger). Firms have many good reasons to merge that can be described as

efficiency enhancing. The most important is that merging firms can create synergy (two or more

forces working together so that their combined effect is greater than their individual efforts). Also

lower overhead costs make it easier for the firms to broaden supply and grow faster.

Merger can have positive or negative effect, therefore government agencies to authorize mergers

called merger control.

Mergers can create or increase market power by eliminating competition and being able to abuse

that position. Upstream market: market for an input to a product. Downstream market: market for a

product that uses the input of upstream markets.

When by merging the situation is created where each firm knows that the other knows that a price

rise would be profitable for both, this is called the creation of a collectively dominant situation.

Different sources of rising costs associated with the expansion of vested interests

- Increase in size leads to increase of administration and organization costs



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- Change of property rights assignments to the agents within merging firms (affects incentives)

- Number of innovations declines as managers may be less motivated by having to share gains

- Adjustment costs because of restructuring (workers training)

How members of the organization behave depends on the organizational culture, there can be

distinguished between four types:- Power culture, one individual or one group forms the power base of the organization.

- Role culture, individuals are controlled by procedures, role descriptions and authorities.

- Task culture, emphasis is on results, and individuals are empowered with discretion and

control over their work.

- Person culture, the organization serves the individual (organization with highly trained

professionals are an example).

Chapter 7 pg. 235 - 251

Cooperation is a governance structure that in the TCE literature is called a hybrid, a structure of

collaboration combing elements of both market and hierarchy.

Need for cooperation can be shown with aid of the prisoners dilemma, in this game there is no

possibility of cooperation, and therefore the result of the game is that no optimal outcome is

reached. A situation like this can only be avoided if effective institutions have been developed to

make agreements possible and enforceable. Effective sanction induce people to keep to agreements.

Some cooperation can benefit the firm, but can affect others negatively, like cartels. Cartels can have

a negative influence on consumer welfare, which is why they are prohibited by competition laws.

This way cooperation is restricted to be only welfare enhancing and not anti-competitive.

Sometimes gains outweigh costs and cooperation is allowed even if it is competition restricting.

So there are three types of agreements to cooperate:

- Noncompetition restricting agreements

- Competition restricting agreements that increase total welfare

- Competition restricting agreements that decrease total welfare

Cartel/Collusion: welfare decreasing, competition-restricting behavior.

A common form of cooperation are partnerships based on proven professional knowledge.

There are five main real-life examples of hybrids:

- Keiretsu, a cluster of independent, autonomous organizations that coordinate their

transactions without any of them being the central player. Two different types:

- Horizontal, equality and freedom to borrow from other banks or use different trading

services.

- Vertical, inequality, the leading enterprise dominates the other enterprises. Management is

controlled by a core firm.

- Cooperatives, an association of autonomous individuals or firms who seek their common

goals through a jointly owned and democratically controlled enterprise.

- Licensing, involve the transfer of a property right. A license contract addresses issues such as:

- brand name or trademark

- quality standards

- the period the license will cover

- the geographical area within it is allowed to sell

- minimum fees that have to be paid

- how the relationship will be concluded when the license ends

- Franchising, the licensing of a business concept of a franchisor to a franchisee. A franchise

agreement includes, among other things:

- fee that has to be paid



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- name or trademark it covers

- audited financial statements of the franchisee

- estimate of the total investment of the franchisee

- supply arrangements

- dress code of the employees

- training the franchisor will provide to the franchisee and his employees- other substantial assistance such as marketing plans and operating manuals

- Islamic banking, organization form of a limited partnership to fulfill a particular or temporary

objective. The bank contributes financial assets and the firms contributes productive assets

Hybrids arise when transactions involve moderately specialized production factors, or semi-specific

investments. If investment is semi-specific to high specific, the hybrid is more effective than other

private governance structures.

The efficiency in transaction costs in hybrids can be lower because of:

- Complex contract law, this regime allows contracts to be mediated by a flexible enforcement

system (arbitrage) rather than courts. Applies to disturbances that are costly enough to look

for adjustments. As they does not occur too often, arbitration involves lower costs thancourts.

- In the case of hybrids it is not always necessary to pool all assets. Actors may decide to pool

only a proportion of their property rights in order to be more efficient, while retaining full

autonomy over the others. In this way they remain flexible and will be able to adapt to

market development in the way they see fit as autonomous owners/managers.

- Brand names require the implementation of modes of control between partners to secure

the reputation of the brand. Incentives to behave opportunistically are constrained in

horizontal networks, because reputation effects are quickly communicated in nonhierarchical

contracting relations, and because sanctions are available to partners.

- Mutual adaption to risks is favorable. Large investments may be too much of a risk for one

firm and therefore the firms cooperate and spread the risk. But cooperation itself also

involves risks:

- Clash of cultures, for example workers who do not want to be supervised by a foreigner.

- Lack of trust, the less partners trust each other the more has to be stipulated in contracts.

- Lack of cooperation, managers pursuing different goals than the CEOs goals.

- Performance risk, despite full commitment of a partner, this partner may fail.

A hybrid is a governance structure where parties remain legally autonomous, but are mutually

dependent for important decisions. Because of this mutual dependency a hybrid is sensitive to

hazards that stem from information asymmetries. Partners must thus be selected carefully, and

selection is mostly done on past experience and reputation.

Essential question is: How to arrange the protection and distribution of the gains of the cooperation?

Difficult to measure individual effort and contribution to the gains. One solution to induce partners

to maximize their joint is the equity principle (share everything equally).

In several instances, cooperation is not aimed at increasing overall economic welfare. There might be

a strive after own interests at the expense of others. Two illustrations:

- The green lobby, the growing involvement of governments in farming has been accompanied

by lobbying by vested interests to benefit the agricultural sector. Farmers are supported by

ministries, universities etc. Also farmers might enjoy tax benefits, which is certainly

inefficient.

- Cartels, form ofexplicit collusion. Also implicit collusion: firms do not have to agree to raise

prices simultaneously, they just know it will benefit them and the other firms. Cartels are

overall decreasing economic welfare, but are in the vested interests of the firms involved to

eliminate competition.



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Chapter 8

State intervention is needed when public interests are at stake.

Public interest -> market imperfections that cannot be solved by private actors.

Forms of market imperfection:

Imperfect information

Private parties are unable to detect or signal the true quality of an asset at reasonable cost (fewer

products are traded, and certainly fewer products of good quality)

Market power / natural monopolies

The existence of a sole supplier or a cartel may reduce economic competition to such a degree that

consumers are forced to pay high prices

Externalities

Economic side effects, which harm third parties without compensation

Pure Public goods

Assets that are characterized by non-exclusiveness and non-rivalness, which leads to the problem of

free riding behavior, with the consequence that a private market for the asset in question will

generally not arise.

The static approach to state intervention

Why are transactions coordinated through different governance structures?

Bounded rationality and market imperfections my lead to opportunism to such an extent that the

general public needs to be protected by the government.

Imperfect information

Two types of imperfect information:

- Knowledge can be distributed unevenly among the different actors, so that some could use itto their advantage (Difficult for consumers to obtain reliable information about the prices

and quality of goods for sale)

- Knowledge can be imperfect for all the actors involved (actors cannot take benefit of theimperfect information, but are just not able to obtain the relevant information to undertake

a transaction)

Private safeguards: contracts / informing by consumer associations / disclosure of relevant

information of products / offering warrants etc.

Result of market imperfection :

- fewer transactions take place than would be the case if people had complete oversight, with

respect to goods as well as to investments, referred to respectively as underconsumption and

underinvestment

- transactions might disappear completely, when people are not willing to pay the market price that

is based on averages

State interventions:

- Requirement for producers to give sufficient information about the goods that they areselling to the public, therefore increasing information (e.g. electrical appliances)

- Price tags / price per unit- Enclose information leaflets with their products about the composition and side effects of

medicines

- Qualifications should be disclosed- Inspection agencies, monitoring the behavior of private suppliers

Lemon law: law that provides remedies to consumers for mechanical products that repeatedly fail to

meet certain standards of quality and performance



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Sector-specific state intervention

Intervention in certain sectors of professions (credence goods = consumers have to trust that the

service offered is of good quality), that are considered to be of great importance to the public

(lawyers / doctors / health and social insurances)

These sectors of professions can be monitored by the state or by self-regulatory inspection agencies.Self-regulation agencies:

Advantage -> have the specific knowledge needed to monitor in the most efficient way, they can

react more swiftly to changing circumstances, and the monitoring costs are borne by the profession

itself

Disadvantages -> members of the profession can act as a special interest group that may abuse its

specific knowledge. They could also abuse the information asymmetry by creating unnecessary

supplier-induced demand (e.g. making clients believe that they need to take out extra insurances)

State agencies:

Can set minimum quality standards and install a specialized public monitoring agency that oversees

the quality of the supplied services and guards against deceptive advertising. And it can issue licenses

that can only be obtained by members of the profession after they have been able to show proof oftheir expertise.

Intervention in pharmaceutical industry -> to protect the health of the population, because that

affects economic growth

Intervention in social insurances -> made mandatory to protect individuals from the lower class. By

making it mandatory the costs are spread over the entire population and it is affordable to everyone

Intervention in the financial sector -> to stimulate economic growth, by increasing transparency and

building in financial security (can be done by nationalization of banks/mortgage lenders, as seen in

the US -> done to prevent consumers from losing their confidence in the entire banking system and

creating a domino-effect)

Market power and natural monopolies

Governments actively combat market power when it is believed to threaten the public interest (e.g.

paying high prices due to one sole supplier). Governments may therefore try to stimulate

competition in the market (3 bus companies on the same route) or for the market (3 bus

companies fighting for the monopoly for a certain period of time).

Monopolistic competition

Many suppliers of different but very similar products. Because each seller offers a slightly different

product, she is the sole supplier and hence a sort of monopolist. She can determine her own price,

but not too high, since she would lose customers.

This market power is however not to be intervened, since this would lead to an even worse market

imperfection.

Monopoly

In general, it is not forbidden to have a monopoly position (if it is created by superior competition),

but it is not allowed to abuse this position

Good things about monopoly:

- Monopoly power may be regarded as the reward for superior competition. By taking risks,being innovating etc. If this wouldnt be allowed there wouldnt be an incentive to take risks

or be innovative.

- Related to this, there are patents, which gives the inventor the legal right to reap thebenefits of its invention for a period of time. If these patents werent there, inventors would

not have the possibility to earn its cost back and there would be a risk of free-riding, taking

away the incentive to invent.



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- The monopoly price is an important incentive for others to enter the market, so competitionmight be created or encouraged by the monopoly situation.

Fixed costs argument

If a firm has high fixed costs, expansion of its production will lead to decreasing average total costs,

which implies that marginal cost is lower than average total cost. The result of such a situation for a

firm without market power is that, since the price is equal to marginal cost in the case of perfectcompetition, and marginal cost is below the average total cost, the price is below the average total

cost. Therefore: there will be a loss for this producer

To be able to make up for high fixed costs, the price must be higher than marginal cost: market

power is necessary to be able to pay for high fixed costs

Competition policy

Intervening of firms abuse their dominant position, for example cartels or mergers that can dominate

a market.

Implicit collusion: A small number of firms, each understands that raising prices will be followed by

the others because it is in their own interest to do so.It is hard for a competition authority to win a case against firms that decide to raise their prices

independently. So generally speaking, a competition authority will only be able to intervene in the

following three situations:

1) When market power is abused by (existing) dominant firmsAbuse can be described as behavior that is beneficial to the firm, but that adversely affects

consumers (raising rivals cost = making it difficult for small competitors or entrants to

compete / predatory = prices are too low to exclude competitors form the market, but

afterwards prices may be raised to a higher level as compared to a situation without

predatory behavior)

2) In order to prevent the possible (future) abuse of a dominant position when a merger isannounced a competition authority will try to assess whether this merger will change the

market structure in such a way that competition may be substantially lessened.

Intervention can be that the merger is not allowed, or only partially (e.g. selling part of its

business)

3) When market power is exerted as a result of explicit collusion by cartelsCartels will make agreements on for example, higher prices, lower quantities sold, client

groups that are assigned to the members of the cartel, or geographical areas that are allotted

to the members of the cartel. This will always lead to higher prices.

Means of competition authorities:

- Investigate all digital material- Sometimes even search individuals houses- Fine firms- Firms are obliged to cooperate

Leniency policy for cartel involvement = the first firm that cooperates actively and confesses and

helps collecting evidence for previous or existing cartels gets a much lower fine than the rest

Natural monopolies

A natural monopoly is intrinsically good for an economy in terms of cost efficiency. Yet its monopoly

character also implies that monopoly pricing will lead to an allocative inefficient solution

(deadweight loss). Therefore usually such monopolies are regulated.

Usually these monopolies have high fixed costs or have increasing return to scale (thats why they

can become natural monopolies). Where these apply, average cost declines with output. If the firm is

large with respect to market demand and average cost decline, this means that it is cost efficient to

have only one firm in the market.



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A natural monopoly, resulting from high fixed costs, will be a problem only if there are entry barriers.

If an alternative producer is able to enter the market with a similar kind of production process, this

producer will have to incur the same fixed costs. This newcomer will only enter the market if he can

produce the goods more efficiently, and only then will the second producer be able to take over the

market from the original monopolist.

Regulation of natural monopolies

From the point of view of Allocative efficiency and cost efficiency, the government requires that a

natural monopoly sets a price that is efficient. Since the monopolist will not set such a price

voluntarily, he must be forced by law to do so, and some agency is needed to enforce this legislation.

Allocative efficiency is reached when price is equal to marginal costs. But with declining average

costs, such a price implies losses

- Loss could be compensated -> subsidize or cover the loss with a fixed feeTwo part tariff: a fixed fee to cover the loss, and a (variable) fee per unit of output at the efficient

pricing level

The creation of competition for the marketAnother way of solving the problem of a natural monopoly, is creating competition for the market.

The government selects a firms that can start producing a product. A few competitors therefore have

to give a proposal to the government. The one with the lowest costs or the highest revenue for the

government will be chosen. Therefore a monopoly will automatically choose his lowest possible

price, therefore not creating monopoly prices. The firm that is chosen is awarded a concession (= a

contract or license associated with a degree of exclusivity in business within a certain geographical

area). Example bus companies. This exclusive right is called a legal monopoly

Externalities

Greatest human externality probably emanate from environmental pollution as a by-product of

economic activities. From both consumer (throwing bags away) as producers view (contamination of

soil). The person responsible can often not be called to order effectively by private actors for a few

reasons:

- The offenders may be large in number and located worldwide- People responsible are not aware of the damaging effect of their actions- People may be very well aware of the problems they are causing but intend to continue their

activities because they have the power to do so (powerful multinationals)

- Third parties that are being harmed by negative side-effects often do not make up a well-organized, homogeneous interest group, also lacking the financial means

When a complex negative externality involves causers and aggrieved parties on a world-wide scale,

governments of different nations need to negotiate about international solutions.

Emissions trading: a trading market for emission allowances. If a firm wants to emit more than their

allowance, they can buy emission from a company that is emitting less than its allowance.

Government interventions:

- Tradable pollution rights emission trading- Awareness programs alcohol- Financial (dis)incentives or product bans tobacco / noisy air companies- Quotas overfishing- Import blockings

Positive externalities

Well functioning health care system and the educational system

Health care -> vaccination. (subsidized by government to protect all people, otherwise people

wouldnt get themselves vaccinated)

Education -> subsidized to increase opportunities for everyone resulting in higher economic welfare



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TCE approach to public ordering

Which governance structure is the optimal choice in a given institutional environment? So, if a

society encounters an incidence of a market imperfection, and hence with an inefficient outcome,

what would be the best way to coordinate the transaction?

1)

Indicative rules with respect to information disclosuremildest form of government intervention. The rules specify only how much information

should be made available so that prospective transaction parties know better what they are

getting involved in.

2) Monetary incentivestaxes, subsidies, and minimum or maximum prices go one step further, as they steer the

autonomous decisions by private actors in a desired direction. Actors are still free to choose

how to transact, but because of taxation and subsidies, they will take different steps

3) Constraining rules with respect to quantity and qualityThe degree of maneuverability decreases even more for private actors as a result of

constraining rules. These kind of rules will limit the options that actors have at their disposal.

For example firms that are only authorized to supply certain goods if they have an officialpermit.

4) Strict requirements (directives) with respect to legal monopoliesFirms are now not even free to choose how much they want to produce and at what price. A

firms autonomy is lost in order to prevent the abuse of their market power

5) Complete state control through public monopolies (state-owned enterprises)Government decides to take production in its own hands.

Chapter 9

Public interference itself has costs, so that on balance this intervention might not improve welfare.

On some occasions this happens inadvertently, while the government strives to protect the publicinterest but fails to do so. On other occasions this is the result of purposeful behavior aimed at

serving the vested interest of only a minority of the population.

Running a government involves, among other things, monitoring costs and enforcement costs by the

public administration, compliance costs by the citizens and efficiency losses resulting from actions by

civil servants and politicians who are not necessarily optimizing welfare.

Implementing state policies requires the involvement of the public administration, which leads to a

range of expenses associated with running governmental bodies. -> enforcement costs and

monitoring costs (financed mainly out of taxes)

Additionally, citizens incur compliance costs when they are subjected to public policies (e.g.

paperwork needed to complete a tax declaration or to apply for a permit)

The static approach to government failures

Difference made between problems and costs in situations of perfect information (transparent

setting, new institutions may neutralize the decrease in social welfare) and imperfect information

(non-transparent setting, more difficult to tackle unwanted effects).

Government failures in situations of perfect informationThe Arrow paradox: the battle of the sexes. The government is unable to translate individual

preferences into a social preference. Due to majority voting on specific parties, there are always

people pro or against certain implementations



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Cost-benefit analysis and compensation

Compensation: Pareto versus Hicks-Kaldor: When a government intervenes in the economy in the

public interest this could nevertheless work out unfavorably for one or more groups in society.

(Tackling environmental issues might reduce the amount of the product that caused the pollution,

due to higher prices / non-smoking regulation in restaurants led to people having to close down their

restaurants) -> government might opt for compensation, compensating losers over winnersPareto efficient -> situation in which no individual can be made better off without someone else

being made worse off. Pareto improvement -> at least one actor can be made better off without the

other being made worse off.

Sometimes there are more Pareto efficient situations. Which to choose?

Compensation can solve these issues: if welfare is improved, this must imply that on balance there

are more gains than losses. A social cost-benefit analysis should be able to show that on balance a

choice is optimal if this choice generates the highest overall profits. Subsequently, losers could be

compensated by winners in such a way that in the end nobody is worse off. This is called the Hicks-

Kaldor criterion.

The Hicks-Kaldor criterion might however not always work. In the case of adverse selection (see box

3.5), it might involve to much costs to get more information, and compensation does not work

Property rights problems

When someone owns the property right of a good, it will usually lead to optimizing behavior. High-

powered market incentive (in the face of competition, when the holder of a private property right

increases his efforts, this will have an immediate positive effect on his income) and private property

rights are stimulated as it will carry over the growth in the entire economy.

In the case of a public good (produced by a private firm or state-owned enterprise), there is a risk of

having civil servants running the public firm having low-powered incentives, due to no competitive

pressure. Managers of these state-owned enterprises feel less inclined to monitor or encourage their

employees with the aim of making them work harder or more efficiently (lacking the urge to

minimize costs).

Public vs. private provision

With regard to the choice between the public and private provision of products, three dimensions

are involved: decision-making, finance, and production

Producing itself = produced by civil servants

Financing itself = financed by tax or revenues from state-owned natural resources

When both are done by the government we call this pure public provision

Two other options: government financing private firms to produce goods (UK universities)

Private firms financing public goods (public transport)

Accountability

Even if the government decides that the provision of certain goods and services should remain under

state control, there are means by which civil servants can be disciplined to work efficiently, by

making them more accountable for running the agency in a cost-minimizing way

National audit bodies: independent public agencies tasked with monitoring and evaluating the

effectiveness and efficiency of all public sector departments

Remuneration

Another way to motivate government officials to operate the civil service more efficiently is to build

in positive incentives such as a pay increase or variable pay instead of a fixed salary.



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Incentives for citizens regarding public goods

Citizens behaviour will also generally lead to efficiency losses: if the price of a product is zero for

consumers, demand increases, possibly enormously, resulting in a situation of overconsumption (free

health care)

Furthermore, if a public service has a fixed price for everyone, people tend to make inefficient use of

it (no incentive to separate the garbage)

Government failures in situations of imperfect information

Unintended side effects

The economy is so complex and wide-ranging that the effects of newly introduced policies are very

hard to predict.

Different types of side effects caused by: tenders, licensing, taxation and subsidies, and so called

false positives and false negatives

Tenders

Government often invite construction and engineering companies to tender for large infrastructuralprojects. In terms of an auction, the government sells a large project and the companies try to buy

the project.

Bid rigging: with bid suppression, one or more competitors agree to refrain from bidding or withdraw

a previously submitted bid so that the designated winning competitors bid will be accepted; with

complementary bidding, competitors agree to submit bids that either are too high to be accepted or

contain special terms that will not be acceptable to the buyer; and with bid rotation, all the

conspirators submit bids, but take turns at being the lowest bidder: competitors may take turns on

contracts according to the size of the contract, allocating equal amounts to each conspirator.

Licensing

One shortcoming of licensing occurs when a government is not completely informed about changedmarket conditions, and maintain the number of permits at too low or too high a level.

Another shortcoming might be the background of a person. Highly-educated refugees might not be

assigned a license and therefore get a low-skilled job

Taxation and subsidies:

The existence of taxes and subsidies may spur opportunistic individual actors to try to find loopholes

in the law or even to break the law to turn over as little money to the government and to collect as

much money as possible (e.g. unemployment benefit along with side working). Can only be

combated by strict monitoring.

Evading taxes: micro level -> moonlighting (zwartwerkers)

Macro level -> firms might transfer their business to another jurisdiction where a lower corporatetax rate is levied

Change legal form of a company

Private equity solution (from public to privately owned)

Crowding out: higher national income -> higher money demand -> higher interest -> lower private

spending -> lower private investment -> national income reduces -> fewer goods may be produced

Countercyclical policy: e.g. lowering taxes while already in an economical upswing

False positives and false negatives

False negatives: not convicting someone while he did commit a crime

False positives: convicting someone while he didnt commit a crime



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In economic terms: E.g. Fining a firm for forming a cartel, while this was not the case (false positive)

Principal-agent problems between politicians and the bureaucracy

Politicians might have the ambition to stay in power, therefore striving for vote-maximization rather

than efficiency.

Different agencies:

Delivery agency: provides products and services directly to citizens and firms (hospital)

Transfer agency: ensures that flows of money flow between the government and private actors

(Ministry of social affairs)

Regulatory agency: main task to monitor and control individuals and organizations (competition

authority)

Contracts agency: engages in concluding contracts (Defense ministry)

Control agency: ensure that public agencies spend their budgets effectively

Principal-agent problems between politicians and the voters

Ex-ante election: to get elected politicians might make promises that sound good, but are unrealisticEx-post election: similar ignorance on the part of the electorate enables the politicians to act in ways

that voters did not expect from them

Means to compensate for the weak influence of individual voters:

Ombudsman: independent official who can be approached by any citizen when she has a complaint

against a governmental representative or public agency.

Freedom of information legislation: gives all civilians the right to request and receive information

from the government about the greater part of public decision-making. Can be very effective if there

is a freedom of press.

The dynamic approach to government failuresRegulatory riskFor private property right to function well it is important that the decision right of the owners of

private property are not changed by a government in an ad hoc and unpredictable way. If that were

the situation, that private property rights would not provide stable expectations among actors about

the behavior of the other actors in the economic system. However, in practice, because of action by

the government, private property rights run the risk of expropriation, which will cause a change in

individual behavior (e.g. change in taxation).

Might also have an international effect, due to bad reputations formed by specific actions, causing

lower foreign investment.

Rent-seekingRent-seeking behavior when looked at in a negative way, can be described as a manipulative attempt

to transfer resources in order to obtain favors without competitive effort.

Rent-seekers will try to influence political decisions related to distributing income to their advantage.

Relative small groups can be more effective in reaching their goals than larger groups:

- Individuals who join any large group in order to strive collectively for certain benefits willhave the incentive to let other group members do the work for them

- This problem gets worse if the desired outcome shows the characteristics of a pure publicgood, of which no one can be excluded once it has materialized

- Large groups must share the prospective success with many others- In a large group, the risk increases that not all members of the group have exactly the same

goal- The costs of organizing and monitoring the groups activities also rises with size.



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Lobbying

Difference in influencing political decisions between buying, lobbying and suing

Buying = with financials means influencing political decision-makers

Lobbying = providing information in the hope of influencing the opinion of politicians

Suing = the issue is taken from the political scene to the court

Successful rent seeking means that the requested favors have been granted -> rent-creation

Lobby groups can contribute to efficiency in a sense that it provides politicians with information that

might otherwise by costly to gather. However, lobbying is largely considered to be inefficient (when

successful, the granting of favors must be paid for by the whole population, increasing deadweight

loss).

Logrolling: trading votes; getting votes for a specific proposed law in exchange for votes for another

law about which the party is rather indifferent

Pork barrel politics: politicians channel funds to particular subgroups in society in return for political

support


Summary ins economics

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